Submissions – Financial Sector
Submission to the Inquiry into Access for Small and Medium Business to Finance

This submission is in two sections, reflecting the Inquiry's terms of reference.
The first section summarises recent developments in small business finance.
The second discusses the state of competition in lending to small businesses.
This submission updates the Reserve Bank's submission to the Senate Inquiry
into the Access of Small Business to Finance in March
2010.[1]
The main conclusions are:

Lending to small businesses has increased slightly over 2009 and 2010, after
growing steadily over the decade prior. The slowdown reflects both reduced
demand from businesses and a general tightening in banks' lending standards.
Small businesses in most industries have been able to access funding throughout
the financial crisis, albeit on less favourable terms than previously.

Higher funding costs and a reassessment of risk have resulted in an increase
in the spread between the rates that lenders charge on business loans and
the cash rate. The Reserve Bank Board has taken this into account in its monetary
policy decisions, and the cash rate remains below its average since the end
of 1996. Lending fees have risen, though for most businesses, these represent
a small part of the overall cost of a loan. Fees charged on deposit accounts
have fallen as banks compete more aggressively for this source of funding.

Competition in the small business lending market eased following the onset
of the financial crisis, but there are some early signs that competitive pressures
are again beginning to intensify in some segments of the business lending
market. This should continue as the economy continues to strengthen.

Trends in Intermediated Small Business Finance

Businesses use a combination of debt and equity to fund their operations. Compared
with large companies, smaller businesses tend to make greater use of debt funding
and less use of equity funding; the latter is generally limited to the personal
capital of the owners. Small businesses rely mainly on loans from banks and
other financial institutions for their debt funding, as it is difficult and
costly for them to raise funds directly from debt capital markets. Most lending
to small businesses is secured against residential property.

There is no single measure of what constitutes a small business, and so the Reserve
Bank uses several measures to delineate small and large businesses and the
finance flowing to these sectors. One measure of finance provided to small
business is lending to unincorporated enterprises. Another is based on the
size of loans, where it is assumed that loans of less than $2 million are generally
provided to small businesses, while loans larger than $2 million are assumed
to finance larger businesses. No further breakdown of loans above $2 million
is available, and hence, it is not possible to provide any further information
on financing to medium-sized businesses.

Lending to unincorporated businesses by banks has continued to grow over 2009 and
2010, albeit at a much slower rate than in the prior few years (Graph 1).
The other measure – loans of less than $2 million – shows a similar pattern.
The value of these loans outstanding was little changed since the beginning
of 2008 after growing steadily over the previous decade. In September 2010,
the total value of all loans smaller than $2 million was around $200 billion
and accounted for about 30 per cent of total business lending by banks.

Graph 1

In contrast, borrowing by large business has fallen as these businesses have raised
new equity capital to repay debt and have scaled back their debt-funded
acquisitions.[2]
Banks have also tightened their lending standards for large businesses (as
they have for smaller businesses – see below).

In September 2010, the majors accounted for about 86 per cent of the total value
of business loans smaller than
$2 million, compared with 74 per cent of larger loans (Graph 2).
The smaller Australian banks account for most of the remaining lending to small
businesses. Foreign-owned banks provide only a small share, in part because
they do not have a substantial branch network.

About two-thirds of lending to small businesses is through commercial bills and other
loans with variable interest rates. The remaining third of lending is at rates
that are generally fixed for between one and five years.

Graph 2

The slowdown in small business credit growth over the past couple of years reflects
both demand and supply factors. Small businesses' demand for debt funding
fell as the increased uncertainty about the economic outlook led them to scale
back their capital expenditure plans and focus on reducing their existing debt.
On the supply side, financial intermediaries tightened their lending standards
during the recent economic slowdown as their non-performing assets rose. Small
business borrowers have faced lower loan-to-valuation ratios, stricter collateral
requirements and higher interest coverage ratios.

Business surveys suggest that the availability of finance is not the most significant
factor concerning small businesses at
present.[3]
According to the PwC/East & Partners Business Barometer, the availability
of credit appears to have been less of a constraint than it was a year ago.
In September 2010, 37 per cent of businesses expected the availability of credit
to be a constraint in the year ahead, compared with 82 per cent of businesses
surveyed in late 2009. By comparison, in September 2010, around 60 per cent
of businesses cited global economic conditions and a general deterioration
in confidence as an impediment on business activity. Likewise, the Sensis Business
Index and ACCI Small Business Survey suggest that issues such as lack of sales,
economic climate and future cash flows are more of a concern for small businesses
than the cost and availability of debt financing. NAB's Quarterly SME Business
Survey indicates that cash flows, global economic uncertainty and a lack of
demand are significant issues facing around 30 per cent of small and medium
businesses, while credit conditions remain a concern for around 15 per cent
of businesses.

In aggregate, the available data and liaison by the Reserve Bank, including through
its Small Business Finance
Panel,[4]
suggest that small businesses in most industries have had tighter but still
reasonable access to funds throughout the financial crisis. Property companies
are a notable exception. Smaller developers may have also faced financing constraints
as a result of the contraction in mortgage trusts. Liaison suggests that recent
concerns for the retail and agriculture sectors have also resulted in some
banks monitoring these sectors more closely.

Interest Rates

In setting their interest rates on small business loans (as well as on loans to large
businesses and households), lenders take into account their funding costs and
the perceived riskiness of the borrower.

In the decade prior to the financial crisis, small business indicator rates generally
moved in response to changes in the cash rate, which were the predominant driver
of changes in funding costs. The average outstanding rate on small business
loans declined, however, as there was a gradual fall in the perceived, and
realised, riskiness of small business borrowers during this period (partly
due to the increased use of residential property as security).

One common concern of small businesses is that interest rates on residentially secured
small business loans are priced at a premium to residentially secured housing
rates. However, this pricing results from the higher expected losses on small
business loans as well as the larger amount of capital that banks hold as a
buffer against unexpected losses. In the first case, estimates based on past
experience suggest that small business borrowers are more than twice as likely
as standard mortgage customers to default and, in the event of default, a lender
is likely to lose close to 30 per cent of the small business loan's value,
compared to 20 per cent for housing loans. In the second case, commercial bank
estimates suggest that they hold about three times as much capital against
small business loans as residential mortgages.

As the financial crisis unfolded, the higher cost of deposits and long-term wholesale
funding has seen banks' funding costs increase by more than the cash
rate.[5]
There has also been an increase in the assessed riskiness of small business
loans. This is consistent with the increase in non-performing small business
loans, which have risen to be around 2½ per cent of banks' total small
business loan portfolios as of September 2010 (Graph 3). This is up from
a little under 1 per cent during 2005–2007.

Graph 3

As a result of the above factors, the average residentially secured small business
rate is estimated to be currently about 180 basis points above the residentially
secured housing loan indicator rate (Graph 4), compared with a differential
of about 95 basis points at the beginning of 2008.

Graph 4

Reflecting higher funding costs and a reassessment of risk margins on business loans,
the major banks' variable indicator rate for residentially secured loans
has risen by about 220 basis points relative to the cash rate since mid 2007
(Graph 5). Over the same period, the spread between the actual variable
rate paid by small businesses and the cash rate also rose by about 175 basis
points. Over the decade prior to the onset of the financial crisis the actual
variable rate paid by small business moved much closer to the small business
variable indicator rate, reflecting the strong competition between lenders
and an increase in the use of residential property as collateral.

Graph 5

Indicator rates on new 3-year fixed rate small business loans have risen by about
150 basis points relative to the corresponding 3-year swap rate, a common pricing
benchmark. This reflects both an increase in risk margins of business loans
and an increase in the funding costs for fixed rate loans.

Notwithstanding the increase in spreads as a consequence of higher funding costs
and greater risk, the average rate on outstanding small business loans (including
variable-rate and fixed-rate) has fallen by about 110 basis points from its
peak in mid 2008, reflecting the large net reduction in the cash rate since
then (Graph 6). At the end of January 2011, the average rate on outstanding
small business lending is estimated to have been about
30 basis points above its post 1996 average. This is similar to the
relativity between the current level of the standard variable housing loan
rate and its long-term average.

Graph 6

Over recent years there has also been a marked increase in the range of interest
rates offered for similar products, possibly reflecting banks competing on
non-price criteria. For example, in January 2011, the range between the highest
and lowest rate offered by the major banks on a residentially secured small
business loan was around
120 basis points, compared with 35 basis points in June 2007 (Graph 7).

Graph 7

Fees

The RBA Bank Fees Survey shows that in the 2009 financial year, banks' fee income
from businesses (both small and large) amounted to $7.6 billion, a rise of
13 per cent over the previous
year.[6]
Lending fees – those on loans and bank bill facilities – accounted for just
over half of total fees on businesses, while merchant service fees and fees
on deposit accounts accounted for most of the remainder.

Lending fees increased by about 24 per cent during the 2009 financial year, somewhat
faster than in previous years. The increase in fees on these facilities largely
reflects the repricing of credit and liquidity risks; in particular, fees on
undrawn facilities appear to have risen significantly. However, fees are only
a small part of the overall cost of a loan for most businesses. In 2009, lending
fees were equivalent to about 60 basis points on the stock of banks' outstanding
business lending, around one-tenth of the average interest rate paid on outstanding
business loans.

Based on information released in banks' annual reports, it is likely that the
major banks' banking fee income, derived from both households and businesses,
will decline a little in the 2010 financial year. Details of changes in banks'
fee income from businesses will be available from the RBA's next survey
of bank fees to be published in mid 2011.

Competition in Small Business Lending

Competition in lending is cyclical. During periods of strong economic growth, banks
tend to compete aggressively for business lending by cutting their margins
and relaxing their lending standards. However, when the economic and business
outlook is uncertain and loan losses are rising, as has been the case over
the past couple of years, banks take a more conservative approach.

Reduced lending by the smaller banks and the non-bank financial institutions appears
to have been the main factor in the easing in competition for small business
loans in the recent cycle (Graph 8). Lending by non-bank firms has fallen
by almost a half since the onset of the financial crisis, while lending by
smaller banks remains well below its peak in 2008. In contrast, the major banks
have continued to increase their lending over the past few years. This has
resulted in a significant jump in their market share, accounting for about
three-quarters of lending to unincorporated businesses, and about 70 per cent
of total business credit (Graph 9).

Graph 8

Graph 9

Past cyclical patterns suggest that competition for business lending is likely to
pick up over time and there are some early signs of this in the Reserve Bank’s
liaison with medium and large businesses. Foreign-owned banks are also likely
to look to expand their presence in the market as global conditions continue
to improve.

The PwC/East & Partners Private Business Barometer surveys around 1,100 private
businesses with annual turnover between $10 million and $100 million; around
90 per cent of companies have fewer than 100 employees. The Sensis Business
Index covers approximately 1,400 small businesses and 400 medium businesses
(20 to 199 employees). The NAB SME survey includes about 700 firms with annual
turnover between $2 million and $10 million. The ACCI Small Business Survey
covers small (fewer than 20 employees), medium (20 to 99 employees) and large
business (100 or more employees). The survey generally includes 1,000 to
2,000 firms.
[3]

The Small Business Finance Panel is a group of small business operators from around
Australia that the Reserve Bank convenes to discuss finance conditions in
the small business sector.
[4]